ByRegulatory News

ESRB published the fourth issue of its annual Non-bank Financial Intermediation Risk, or NBFI, Monitor for 2019 (previously called the Shadow Banking Monitor). This report considers a range of systemic risks and vulnerabilities related to non-bank financial intermediation, including those related to interconnectedness, liquidity, and leverage. The report also highlights that further work is required to address remaining data gaps and improve risk assessments by developing metrics to measure liquidity, leverage, and interconnectedness.

The Risk Monitor, which covers data up to the end of 2018, contributes to the monitoring of a part of the financial system that has grown in recent years and now accounts for nearly 40% of the financial system in EU. It identifies several key risks and vulnerabilities in the shadow banking system in EU:

Liquidity risk and risks associated with leverage among some types of investment funds and other non-bank financial institutions

Interconnectedness and the risk of contagion across sectors and within the non-bank financial system, including domestic and cross-border linkages

Activities-related risks—procyclicality, leverage, and liquidity risk—created through the use of derivatives and securities financing transactions

The report reveals that some non-bank financial institutions remain vulnerable to a repricing of risk, with potential spillovers to funding conditions of other financial sectors. In EU commercial real estate markets, transaction volumes and prices are near their previous peak in 2007. Given the increasing role of non-bank financial institutions, new forms of interconnectedness and transmission channels may arise. Cross-border reallocation of commercial real estate funding can result in excessive swings in asset prices and global commercial real estate markets may become more correlated. The growth of leveraged loans also reflects an increase in risk-taking. The low interest rate environment supports strong investor demand for such loan products which offer higher rates of return, but also carry greater risks. In an economic downturn, highly indebted borrowers may then be unable to refinance existing loans, resulting in higher default rates.

Furthermore, the report reveals that the use and reuse of financial collateral in derivatives and securities financing transactions can create intermediation chains, which can spread funding liquidity shocks. Haircut and margining practices in bilaterally and centrally cleared trades may force market participants to post additional cash or other cash-like collateral. Central counterparties, or CCPs, are important entities in helping to reduce risks between market participants. This also creates close interconnections, linking clearing members, which are mostly banks, and their clients such as insurance companies, pension funds, hedge funds, and other investment funds. These clients rely on a small number of dealer banks providing client clearing services. Through the use of repo transactions, interconnectedness between banks and non-banks increased in 2018, with balance sheet data for Euro Area banks showing a 21% increase in liabilities with other entities to EUR 254 billion.